The
deficit chatter is heating up. As Finance Minister P. Chidambaram prepares
for the first budget of his second innings, conversation has begun in dead
earnest on the size of the fiscal deficit. Was his predecessor doing some
window-dressing to keep it under 5 per cent for 2003-04? Given some of the
lofty goals of the Common Minimum Programme (CMP), the wish list of the
worthies who support the government from outside, and the demands of Laloo
and his pals, can the Harvard educated advocate keep the deficit in check
for 2004-05? Is a deficit of 5 per cent sustainable? How does this
government propose to eliminate the revenue deficit by 2009, as promised by
the CMP? These are just a few examples of the discussions that have begun in
the drawing rooms and board rooms of the denizens of corporate India.

Interestingly,
almost all these discussions centre around the Union government’s
deficit. The fiscal problem of the state governments is invariably
forgotten. That’s a shame — because the real crisis lies with state
government deficits and debt, and the truly great fiscal challenge is to fix
these in the next five years.

Every
major state government has been running sizeable budget deficits over the
last decade, if not longer. West Bengal, Andhra Pradesh, Karnataka, Bihar,
UP, Punjab, Maharashtra… each of them have systematically spent much more
money than what they earned. Indeed, the 1990s and the new millennium have
seen more fiscal profligacy by the state governments than ever before. For
example, until a decade ago, Maharashtra was a well managed state that
earned a modest budget surplus. In the last seven years, the Shiv Sena and
the Congress governments have spent way more than what they earned and
methodically bankrupted the coffer.

The
combined deficit of the state governments for 2003-04 is around 5 per cent
of India’s GDP. This is more than the 4.8 per cent fiscal deficit racked
up by the central government’s fiscal deficit in the same year. If you add
to this another one per cent on account of losses of public sector
enterprises and the oil pool — numbers that don’t show up in budgets —
then the total deficit of India exceeds 10 per cent of GDP. As any
self-respecting economist will tell you, this not only ranks amongst the
highest deficits in the world, but is also unsustainable. In simple terms,
we are rapidly being sucked into a debt trap; and we cannot expect to run up
such monumental deficits and then hope that economic growth will bail us out
of the trap.

The
consequence of such profligacy is that the centre and states have
accumulated huge public debt — way more that what they can ever service
through their revenues. Beyond a point, all public debt is bad. However,
those of the states are even worse. Let me explain why.

Unlike
the Government of India, states can’t print notes or issue sovereign
treasury bills. Up to the mid-1990s, the states had less of a problem. For
one, the deficits and public debt were lower. For another, the Reserve Bank
had the green signal from the centre to continuously roll over state
government debt and, thus, effectively offer an open ended overdraft
facility. That stopped when Dr. C. Rangarajan at the RBI and Dr. Manmohan
Singh at the North Block got rid of these “ways-and-means” advances. The
hard budget constraint was supposed to kick in.

But
it didn’t, for a couple of reasons. First, coalition politics with razor
thin margins meant that critical partner states could circumvent budget
constraints. There used to be a joke that every Delhi visit of Chandra Babu
Naidu raised the combined deficit of the nation. Second, investment bankers
with their Hermes ties and their Jermyn Street £300 per pair hand tooled
calf leather laced shoes taught state finance ministers all about Special
Purpose Vehicles and “off-balance sheet” debt. Essentially, states were
told that funds could raised by issuing attractive (read “high cost”)
bonds of public sector enterprises and corporatised projects. Since these
offered high interest rates and were backed by state government guarantees,
nobody quite cared about the quality of the enterprises that were issuing
such bonds. According to conservative estimates, such off-balance sheet debt
was as high as Rs.210,000 crore by 2002-03. Since money is fungible, it is
not surprising that most of it went to financing state deficits.

Even
if we were to ignore the off-balance debt — though it will sooner haunt
the bankrupt states — the stock of official public debt of the states is
very high. Other than putting the states in serious financial risk, the high
debt burden has given many chief ministers the excuse to overlook key
development issues. The argument goes as follows: “After the Seventh Pay
Commission, wage and salary bills have gone up. After paying the centre
interest on exorbitantly high cost debt, why do you expect us to have
anything substantial left for development expenditure?”

It’s
a good excuse, and time has come for the central government to deal with it.
Here’s what I have to suggest. Let the states and the centre design an
freeze a set of clear reform priorities. For instance, the list could
include implementation of VAT by a given date; a number of E-Governance
targets; goals relating to minor and medium irrigation; rationalising of
state taxes and cesses; eliminating procedures that hinder industry;
objectives for primary and secondary education; rural road targets;
electricity reforms; and so on. Three things have to be kept in mind. First,
the targets must be clearly measurable — because without measuring one
cannot monitor. Second, while there may be some state-specific
variations, the list must largely consist of elements that are common across
all states. And third, the targets must have some degree of “stretch” in
them.

Then
the centre can offer the following deal. If a state achieves a given set of
targets in the first year, the centre will (i) swap a well-specified share
of the state’s high interest rate debt to the centre for lower cost debt,
and (ii) retire a certain percentage of debt as well. The first will reduce
the interest outgo from the states to the centre and, hence, leave more
funds on the plate to finance development programmes. The second will
partially reduce the liability of the states, and hence, future interest
burden.

No
doubt, this programme of debt swap and forgiveness for state-level reforms
has to be carefully designed and calibrated. It also requires the discipline
of saying “No” if a state hasn’t met the committed target — which is
not a politically easy task for any coalition government. However, it is
perhaps the only way that I can think of saving the states from utter
bankruptcy. And it will get rid of the excuse of state finance ministers
that they just don’t have the funds for development.

So,
let the centre take an interest and a debt haircut over the next five years
on account of states that are pursuing an agreed programme of reforms.
Reduce the interest burden of the states. And then let’s see what
development they actually do. That’s fiscal federalism in my book.